chapter 3 · chapter 3 adjusting the accounts 2. 1. define the accounting period, the time period...

Chapter 3

Adjusting the accounts

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1. Define the accounting period, the time period principle, the revenue recognition principle and the matching principle

2. Differentiate between the cash basis and accrual basis of accounting

3. Explain what adjusting entries are and why they are needed

4. Explain the four types of adjusting entries and prepare journal entries for each type

Learning objectives

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5. Explain the link between adjusting entries and the financial statements

6. Prepare an adjusted trial balance and explain its purpose in the accounting cycle

7. Prepare financial statements from the adjusted trial balance

Learning objectives

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Define the accounting period,the time period principle,

the revenue recognition principle andthe matching principle

Learning objective 1

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▪The accounting period is a period of time over which accounting information is collected, summarized and reported to users▪But why divide the life of the business into accounting periods?▪Because it enables the business to report information to users to support decisions regarding the business during the life of the business, rather than waiting until the end of the business

The accounting period

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– half-yearly (semiannually) – quarterly

– monthly– weekly

▪How long is an accounting period?▪The accounting period is the period of time covered by the reports produced for the users▪Financial reports that cover a one year time period are known as annual financial statements▪Financial reports that cover time periods less than one year are known as interim financial statements that may be:

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▪A fiscal year is any 12 consecutive months that a business adopts as its annual accounting period▪The fiscal year may not match the calendar year


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▪The time period principle assumes that the economic life of the business can be divided into specific time periods such as a month or a year▪Enables information to be compared from period to period

Time period principle

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▪Dividing the economic life of a business into time periods may result in difficulties in deciding which accounting period to recognize revenues▪For example:

– When cash flows are received in a different period from which the revenues were earned

– When revenues for the one job are earned over several accounting periods

▪The question is, in which accounting period do we recognize the revenues?

Revenue recognition principle

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▪This difficulty is overcome by the revenue recognition principle▪The revenue recognition principle states that revenues are recognized when they are earned– When services are provided to customers– When goods are delivered to customers

Revenue recognition principle

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▪The matching principle states that expenses should be recognized in the same accounting period as the revenues earned from those expenses▪ It aims to achieve the proper determination of net income by matching the revenues earned with the expenses incurred to earn that income within the same accounting period

Matching principle

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Differentiate between the cash basis and

accrual basis of accounting


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▪Cash basis accounting recognizes revenues when cash is received and recognizes expenses when cash is paid

▪Accrual basis accounting recognizes revenues when they are earned and expenses as they are incurred, regardless of whether cash has been received or paid

Cash versus accrual accounting

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▪The distinction is necessary when dividing the economic life of the business into accounting periods▪For example, when cash flows are received in a different period from which the revenues were earned or expenses incurred, cash and accrual accounting will report the revenue earned or the expense incurred in different accounting periods▪GAAP requires the use of accrual accounting

Cash versus accrual accounting

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Explain what adjusting entries are and why they are needed


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▪Adjusting entries are journal entries recorded in the accounts at the end of the accounting period that bring the balance of revenue, expense, asset and liability accounts up to date▪Bring the balance of revenue, expense, asset and liability accounts up to date in preparation for the accounts to be reported in the financial statements

Adjusting entries

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▪Only required under accrual accounting▪Arise because of accrual accounting requires revenues to be recorded in the accounting period in which they are earned and expenses when incurred▪Not required under cash accounting

Adjusting entries

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▪Two main situations that give rise to the need to record adjusting entries:

1. Multi-period items (deferrals)2. Accrued items

Adjusting entries

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1. Multi-period items (deferrals)▪Occur when revenues are earned or expenses incurred over two or more accounting periods▪Cash related to these items is received or paid in an accounting period before the revenue has been earned or the expense incurred▪The recognition of the revenue earned or expense incurred is deferred until after the cash is received or paid

Adjusting entries

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▪Deferrals are recorded in the accounts at the time of the cash receipt or payment but need to be allocated to the revenue or expense account in the accounting periods when they are earned or incurred

Adjusting entries

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2. Accrued items▪Occur when revenues are earned or expenses incurred during the accounting period but have not yet been recorded in the accounts at the end of the accounting period ▪Cash related to these items is to be received or paid in an accounting period after the revenue has been earned or the expense incurred

Adjusting entries

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▪We can expand the accounting cycle introduced in chapter 2 to include adjusting entries

Adjusting entries

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Step in the accounting cycle Documentation

1. Analyze transactions Source documents

2. Journalize transactions General journal

3. Post transactions from the journal to the ledger General ledger

4. Prepare an unadjusted trial balance Unadjusted trial balance

5. Journalize adjusting entries General journal

6. Post adjusting entries from the general journal to the ledger General ledger

7. Prepare an adjusted trial balance Adjusted trial balance

8. Prepare the financial statements Financial statements

Explain the four types ofadjusting entries and

prepare journal entries for each type


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▪There are four types of adjusting entries:1. Prepaid expenses (including depreciation)2. Unearned revenues3. Accrued expenses4. Accrued revenues

▪Remember, adjusting entries are recorded at the end of the accounting period▪The following examples assume a one month accounting period

Types of adjusting entries

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▪ Items for which payment has been made before the benefits are received▪Classified as assets until they are used upExamples:▪Prepaid insurance▪Supplies▪Prepaid rent▪Prepaid advertising▪Depreciation – special case

Prepaid expenses

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▪Prepayment is initially recorded in an asset account when the cash is paid▪

Prepaid expenses

Prepaid Insurance No. 142

360

Date Account and explanation PostRef. Debit Credit

2011

Dec. 1 Prepaid Insurance 142 360

Cash 100 360

(Paid for 36 month insurance policy for the computer.)

Cash No. 100

360

Insurance Expense No. 542

▪Adjusting entry transfers the expense incurred from the asset to the expense account

Prepaid expenses

Prepaid Insurance No. 142

360 Adj. 10

350


2011

Dec. 31 Insurance Expense 542 10

Prepaid Insurance 142 10

(Adjusting entry for one month's expired insurance.)

Cash No. 100

360

360

Insurance Expense No. 542

Adj. 10

10

▪Plant assets are a particular category of prepaid expenses that require adjusting entries to be recorded in the accounts at the end of an accounting period▪Plant assets are tangible assets used by the business over more than one accounting period▪Depreciation is the process of allocating the cost of a plant asset to an expense account over the useful life of the asset

Depreciation

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▪We can calculate the depreciation for an asset using the straight line depreciation method▪Requires three pieces of information:1. Cost

– Expenditure incurred to purchase and bring the asset to its current location and condition ready for use

2. Useful life– The length of time the asset is expected to be used in the

business

Depreciation

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3. Residual value– The amount it is estimated that a plant asset could be sold

for at the end of its useful life

Example:▪Cost = $2,400▪Useful life = 24 months▪Residual value = $240

Depreciation

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Depreciation Expense = Cost – Residual ValueUseful life

= $2,400 - $24024 months

= $2,16024

= $90

Calculating straight line depreciation

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▪Plant asset is initially recorded in an asset account– Note: Accounts Payable ledger not shown

Depreciation

Accumulated Depreciation –Equipment No. 161


2011

Dec. 1 Equipment 160 2,400

Accounts Payable 210 2,400

(Purchased equipment on credit.)

Equipment No. 160

2,400

Depreciation Expense –Equipment No. 561

▪Adjusting entry debits the expense account but does not credit the asset account▪ Instead, depreciation is credited to an account called Accumulated Depreciation▪The accumulated depreciation account keeps track of the amount of depreciation expense that has been charged to the asset to date

Depreciation

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▪The Accumulated Depreciation account is classified as a contra asset account▪A contra asset account is an account linked to a related asset account▪ It is reported as a deduction from that related account in the financial statements▪The normal balance of a contra account is the opposite to its related account▪The Accumulated Depreciation account has a normal credit balance

Depreciation

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▪Adjusting entry for plant assets– Note the balance of the asset account does not change

Depreciation

Accumulated Depreciation –Equipment No. 161

Adj. 90


2011

Dec. 31 Depreciation Expense – Equipment 561 90

Accumulated Depreciation – Equipment 161 90

(Purchased equipment on credit.)

Equipment No. 160

2,400

Depreciation Expense –Equipment No. 561

Adj. 90

Reporting depreciation in the balance sheet

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▪Depreciation is reported as a separate deduction to the cost of the asset

▪The book value of the asset is the cost of the asset less its accumulated depreciation▪ In this case the book value is $2,310

Partial Balance SheetDecember 31, 2011

Assets $ $

Equipment 2,400

Accumulated Depreciation – Equipment (90) 2,310

Total Assets $ XXXX

▪Occur when cash is received from clients beforethe associated revenues have been earned▪Classified as liabilities until the revenue is earned▪Opposite side of a prepaid expense transactionExamples:▪Deposits from customers prior to providing the goods or service▪Magazine subscriptions▪Concert tickets

Unearned revenues

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▪ Initially recorded in a liability account when the cash is received▪

Unearned revenues

Unearned Revenue No. 230

900


2011

Dec. 1 Cash 100 900

Unearned Revenue 230 900

(Received revenue in advance.)

Cash No. 100

900

Revenues No. 400

▪Adjusting entry transfers the revenue earned from the liability to the revenue account

Unearned revenues

Unearned Revenue No. 230

Adj. 600 900

300


2011

Dec. 31 Unearned Revenue 230 600

Revenues 400 600

(Adjusting entry - revenue earned and received in advance.)

Cash No. 100

900

900

Revenues No. 400

Adj. 600

600

Accrued expenses are expenses that:▪Have been incurred during the accounting period▪Have not been recognized in the accounts▪Are due to be paid in an accounting period after the expense has been incurred

Accrued expenses

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Examples:▪Salaries and wages▪Utilities expense▪Taxes▪ Interest

Accrued expenses

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▪Adjusting entry records the expense and the associated payable▪

Accrued expenses

Wages Payable No. 220

Adj. 330


2011

Dec. 31 Wages Expense 620 330

Wages Payable 220 330

(Adjusting entry for accrued wages expense.)

Cash No. 100 Wages Expense No. 620

Adj. 330

▪When cash is paid for the expense in a subsequent accounting period, the cash paid may not be equal to the amount accrued▪For example, the cash payment may partly relate to the expense accrued during the prior accounting period, and partly to an expense incurred in the same period as the cash payment▪A compound journal entry is required to allocate the cash payment to the correct accounts

Accrued expenses

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Example:▪Cash payment = $1,100▪Accrued wages at the end of December = $330▪Wages expense incurred during January = $770

Accrued expenses

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▪Subsequent cash payment

Accrued expenses


2011

Jan. 9 Wages Payable 220 330

Wages Expense 620 770

Cash 100 1,100

(Payment of wages including $330 of accrued wages.)

▪Accrued interest expense can be calculated using the simple interest formula:

Accrued expenses

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Interest =Loan

principal outstanding

xAnnual

interest rate %

x Fraction of time

▪Loan principle outstanding = $4,500▪Annual interest rate = 8% = 0.08▪Fraction of time = 1 month (or 1/12 of the year)

Accrued expenses

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Interest = Loan principal outstanding x Annual

interest rate % x Fraction of time

= $4,500 x 0.08 x 1/12

= $30

▪Adjusting entry to record accrued interest expense

Accrued expenses

Interest Payable No. 225

Adj. 30


2011

Dec. 31 Interest Expense 571 30

Interest Payable 225 30

(Adjusting entry for accrued interest expense.)

Cash No. 100 Interest Expense No. 571

Adj. 30

Accrued revenues are revenues that:▪Have been earned on credit during the accounting period▪Have not been recognized in the accounts▪The related receipt of cash (or other asset) is due to be received in an accounting period after the revenue has been earned▪Opposite side of an accrued expense transaction

Accrued revenues

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Example:▪Provision of services over several accounting periods but cash is due to be received at the end of the job

Accrued revenues

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▪Adjusting entry records the revenue and the associated receivable▪

Accrued revenues

Accounts Receivable No. 110

Adj. 750


2011

Dec. 31 Accounts Receivable 110 750

Revenues 400 750

(Adjusting entry for accrued revenues.)

Cash No. 100 Revenues No. 400

Adj. 750

▪When cash is received for the service in a subsequent accounting period, the cash received may not be equal to the amount accrued▪For example, the cash receipt may partly relate to the revenue accrued during the prior accounting period, and partly to the revenue earned during the same period as the cash receipt▪A compound journal entry is required to allocate the cash receipt to the correct accounts

Accrued revenues

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Example:▪Cash receipt = $3,000▪Accrued revenues at the end of December = $750▪Revenues earned during January = $2,250

Accrued revenues

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▪Subsequent cash receipt

Accrued revenues


2011

Jan. 27 Cash 100 3,000

Accounts Receivable 110 750

Revenues 400 2,250

(Received cash for services inc. $750 accrued revenues.)

Explain the link betweenadjusting entries and the

financial statements


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▪Adjusting entries bring the balance of revenue, expense, asset and liability accounts up to date▪ Each adjusting entry will affect at least one income statement account (a revenue or an expense account) and at least one balance sheet account (an asset or a liability account)▪The Cash account is never used in adjusting entries▪ If adjusting entries are not recorded the balances reported in the financial statements may be understated or overstated

Adjusting entries and financial statements

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Type of adjustment Adjusting entry Balance sheet

BEFORE adjustmentIncome statement BEFORE adjustment

Prepaid Expenses (deferrals)

Dr Expense Cr Asset

Asset overstated Equity overstated

Expense understated Net income overstated

Unearned Revenues Dr Liability Cr Revenues

Liability overstated Equity understated

Revenue understated Net income understated

Accrued Expenses Dr Expense Cr Payable

Liability understated Equity overstated

Expenses understated Net income overstated

Accrued Revenues Dr Asset Cr Revenues

Asset understated Equity understated

Revenues understated Net income understated

Summary of adjusting entries

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Prepare an adjusted trial balanceand explain its purpose in the

accounting cycle


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▪The adjusted trial balance is a trial balance prepared after adjusting entries for the period have been journalized and posted

Adjusted trial balance

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▪The adjusted trial balance contains a list of all general ledger accounts and their balances after adjusting entries have been recorded▪The purpose of the adjusted trial balance is to verify that total debits entered into the accounts is equal to total credits after adjusting entries have been recorded and posted to the ledger

Adjusted trial balance

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Prepare financial statements fromthe adjusted trial balance


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▪The financial statements prepared from the adjusted trial balance now include the updated account balances from the adjusting entries

Prepare financial statements

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chapter 3 · chapter 3 adjusting the accounts 2. 1. define the accounting period, the time period...

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